This Downturn Will Stress-Test Roper's Differentiated Business Model

Summary

• Roper seems likely to see far less damage to its revenue and profit trajectory during this downturn, as a substantial amount of revenue/profit comes from subscription/recurring sources.
• There will be areas of weakness, particularly in Process and possibly including some medical and construction businesses, but Roper doesn't have much problematic end-market exposure.
• Explicitly modeling M&A increases modeling/valuation risk, but it's too significant to the business to ignore.
• Roper seems priced for a high single-digit long-term shareholder return; not the best return available, but likely with substantially less underlying business volatility.

I’d been getting more comfortable with Roper Technologies’ (NASDAQ:ROP) valuation recently, and the shares have held up extremely well so far this year, as the company’s strong recurrent revenue model is likely to see the company pass through this downturn with far less disruption than its industrial peer group. The question remains whether industrials are really a valid peer base anymore, but I don’t expect that to constrain the stock’s popularity.

My model assumes significant ongoing M&A, and there is now increased timing uncertainty on that, but I see little to disrupt the basic model. With an ongoing focus on niche-type businesses with barriers to entry, low maintenance capex needs, and low overall asset needs, I expect Roper to continue generating excellent free cash flow margins and free cash flow growth, even though the shares do otherwise look expensive on its organic growth numbers.

A Healthy Beat

With so much of Roper’s business leveraged to software and other recurring revenue streams, not to mention end-markets like health care and traffic management, there really isn’t a good peer group for comparisons anymore. While Roper did join its industrial “peers” with a healthy beat on first-quarter revenue (close to 5%), the organic growth of 4% was quite a bit better than the average industrial showing of around 4% contraction. Roper also did quite well on the segment operating level, beating expectations more than $0.10/share.

All of Roper’s segments produced organic growth this quarter, with Network Software & Systems (or NSS) up 9%, Application Software up 5%, Measurement & Analytical up 3%, and Process up 10%. Segment profits rose 3%, with a 60bp year-over-year margin decline. Measurement & Analytical and Process were the weaker performers, down 3% and 14%, respectively, while NS&S and Application Software grew 13% and 7%, respectively.

Roper once again exited the quarter in a negative net working capital position, the 13^th straight quarter of that.

A Diverse Mix With High Recurring Revenue Will Likely Hold Up Well

Relative to most other companies, Roper does not look all that vulnerable to the COVID-19 downturn currently underway. While other companies have warned investors to prepare for June quarter revenue declines of 20% to 30%, Roper guided to a mid-single-digit decline. Management also provided more insight into the business units, invaluable given that Roper hasn’t been through a meaningful recession since its transformation toward software really began in earnest.

Within Application Software, Roper saw mid-single-digit growth from Deltek this quarter, and government-related work is likely to hold up fairly well. Management is expecting some pushouts in new licensees for Aderant, PowerPlan, and CBORD, but perpetual licenses are only about 10% of the business; 70% of the business comes from recurring revenue sources where annual attrition is less than 5%.

At NS&S, most of the businesses serve end-markets that are likely to see less of an impact from the downturn, including industries like health care, insurance, and logistics. Health care system IT spending could be weak this year, though, and I’m more cautious on ConstructConnect given my weaker outlook for non-residential construction investment in the next couple of years.

Measurement & Analytical benefited from strong demand for GlideScope (driven by intubations), and there’s a risk of more challenging comps for the next year. I’m also a little concerned about potentially weaker municipal budgets impacting Neptune, but I won’t call that a serious worry.

Process is where the trouble will come, with management expecting a 30% downturn next quarter after seeing a high-teens decline in the oil/gas-facing businesses this quarter. I think management is being prudent in not expecting a recovery in 2020, and I think upstream oil/gas is likely to need several years to sort itself out. I’m also not so bullish on Compressor Controls; while Roper’s CCC business has been designed into almost every LNG project, I expect meaningful delays across the sector (something I’ve written about in reference to Emerson (EMR) and Chart Industries (GTLS) as well).

The Outlook

Roper today may be a good example of, “if it’s not broken, don’t break it”. Management has created the less-cyclical (even if not completely acyclical), cash-generating business it wanted, and now it’ll get stress-tested through this sharp sudden downturn. Management sounds no less enthusiastic about M&A now, though they did acknowledging getting deals done in the current environment is going to be challenging. I expect M&A may be on hold until late 2020 or early 2021; many companies will not want to sell at current/recent valuations, but if the recovery doesn’t start to materialize by then, attitudes may change.

I continue to model Roper with the expectation that management will reinvest considerable capital into additional M&A. With management happy to own more niche-type businesses and generally preferring to keep management in place, I don’t think Roper will have insurmountable difficulties continuing to grow through M&A, though it’s at least plausible that there will come a point where management can’t identify enough targets that both satisfy the cash return on investment criteria and move the needle for shareholders.

I model Roper with the expectation of high single-digit revenue growth (boosted/inflated by M&A), and explicitly modeling M&A adds more complexity and room for error relative to “normal” modeling. I have fewer concerns about the margin and FCF outlook, and I expect Roper to drive its FCF margins toward the high 20%’s.

The Bottom Line

If I valued Roper like I normally would value an industrial, excluding explicit M&A and so on, there’s no way the shares would look even reasonably priced. Likewise, it’s well worth remembering that growth gets more difficult the bigger you get; it’s one thing to produce mid-to-high 20% FCF margins with a business generating $5 billion in revenue; it’s a different challenge to do that at $10 billion or $15 billion. Roper does still appear to offer an acceptable annualized return to shareholders, but I will note that there are a lot of quality names out there trading at bigger discounts with less non-traditional models (for good or bad).

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Tetragrammaton]

What I would term “expensive precision engineering” was the basis of this company a couple of decades ago, and formed the foundation for its very successful partial-transformation into a software and services business. I greatly admire the way that vertical-industry specialized niche businesses have been brought under the Roper umbrella. But the stock price is scary high.

Looking at the future outlook for more acquisitions, ROP is likely to be highly constrained by the huge amount of goodwill on its balance sheet, amounting to about $9 billion of its $18 billion assets as of 12/12/19. In fact the water on the balance sheet is about equal to the stockholders’ equity – deduct the goodwill from the assets, and the stockholders would be left with close to zero. This unlikely impairment may not worry the stockholders, but it’s a problem for ROP in raising more debt for future M&A.

And at the same time what’s left of the “expensive precision engineering” side (about 30% of the company) is subject to the same invidious trend in which complicated pumps, controls and other precision mechanical devices are being replaced by cheap, simple substitutes. The high-value-added complicated bits are replaced by control software, not necessarily coming from the same firm. (This trend is keeping me away from CMI, ALSN and others). I’m keeping ROP stock on my “buy the dip” list, preferably a big dip.

[Stephen Simpson]

"Looking at the future outlook for more acquisitions, ROP is likely to be highly constrained by the huge amount of goodwill on its balance sheet ... but it’s a problem for ROP in raising more debt for future M&A. "

Or ... not.

www.ropertech.com/...

[Frza]

Which other names do you see which trade at more discount? :)
Are you talking about AME, FTV, TDY, TMO? Or do you mean other branches?

What I see at ROP at the moment: a recession-resistant business model. A fair forward PE compared to history and especially considering the high FCF conversion, stability in revenues and track record of management.
Imo ROP offered a good chance to get in at $310 and that was exaclty what I did. I think the company will further increase FCF and stay asset-light which is something I appreciate

[Guraaf]

Super useful article and interesting to see you coming around to accept the elevated valuation levels that never seem to come down.

[Stephen Simpson]

Explicitly modeling M&A makes a big, big difference.
It's also another good reminder that the normal relationships between valuation drivers and valuations tend to break down on the extremes (same thing happens w/ banks; exceptionally high/low ROTCEs deviate substantially from the normal valuation parameters).